Avoiding Retirement Planning Pitfalls with Jim Lange and P.J. DiNuzzo

The Lange Money Hour: Where Smart Money TalksJames Lange, CPA/Attorney
Listen every first and third of each month on KQV 1410 AM or at our radio show archives. Note: Some events referenced in our archives have already passed.

Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.

1. Introduction of P.J. DiNuzzo of DiNuzzo Index Advisors, Inc.

Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg along with CPA and Attorney Jim Lange, and this week, we welcome P.J. DiNuzzo back to the show. P.J. is one of our regular guests. He’s a nationally recognized expert in investment management and was approved as one of the first 100 Dimensional Fund advisors. His Pittsburgh-area firm, DiNuzzo Index Advisors, Inc., was founded back in 1989 as one of the first few hundred fiduciary, or fee-only, advisors in the United States, and it consistently ranks among the country’s top 500 investment companies. Our topic this week is how to invest successfully for financial independence and how to sidestep retirement disasters that can be easily avoided. Let’s face it: Most of us probably don’t know how many variables a top-notch financial and retirement planner really has to consider when helping you plan for your future. Well, there are dozens of them, and we’re going to talk about many of them tonight. We’ll cover topics like whether or not to be a DIY investor, gamma research and behavioral science, how to allocate your assets, diversify, and why passive investing is the way to go. It’s sure to be a great hour of conversation, so let’s get right to it by saying hello to P.J. DiNuzzo and Jim Lange.

Jim Lange: Welcome, P.J.

P.J. DiNuzzo: Hello.

Jim Lange: Before we get into the meat of tonight’s program, I do feel honor bound as a fiduciary to mention that I am not independent of P.J. So, probably 90 percent or more of the guests that I’ve had, in fact, virtually everybody except P.J., I have no interest in their business. If they wrote a good book, I will often plug the book, and by the way, I never pay any guest to come on. With P.J., it is different. I do have a financial interest with him. P.J. and I have an arrangement whereby if somebody comes to our office and, let’s say, goes through a long process, which we will talk about, and decides to become a mutual client, the upshot of it is that our office will, we call it running the numbers. We will look at Roth conversions, we will look at Social Security, we will look at how much money people can safely spend, we will look at their estate plan, and, let’s call it, looking at a variety of strategies, which is the strength of our office. P.J.’s office, their expertise is actually investing and doing the asset allocation and choosing the appropriateness of the portfolio and integrating the portfolio that they’re going to manage with perhaps something else that they are not managing, and I think that they are the best advisors we know. They use the best set of index funds, I believe, on the planet called Dimensional Fund Advisors. But anyway, the point is that P.J. and I work together as a team and we split fees. So, I am not completely independent of P.J., and if you like what you hear today and you choose to work with us, P.J. and I will split the fee 50/50. Each of our offices does different things, but I am not independent.

So, with that introduction, why don’t we get into the meat of today’s show, and P.J., you and I share a lot of very sophisticated, very smart clients, a lot of engineers, a lot of physicists and a lot of quantitative people, and some people who, very frankly, are relatively bright and probably could do some kind of reasonable job of being a, what Dan Weinberg called, DIY guy, which is a do-it-yourselfer.

P.J. DiNuzzo: Yeah.

Jim Lange: So, why don’t we talk about who are good candidates to be a DIY guy and who might not be, and let’s say some of the value that an advisor brings to the table we’ll get into a little bit, but why don’t we just start with the issue “Should you be a do-it-yourselfer or should you consider hiring the services of a financial advisor?”

2. Who’s a Good Candidate for DIY Investing?

P.J. DiNuzzo: Yeah, Jim, regarding the topic you were discussing this evening, I mean, how to be a successful investor, there’s basically two ends of the continuum: there would be the do-it-yourselfer, the DIYer, and then the other end of the continuum would be a delegator, that would be someone who is going to delegate one or most or all of their portfolios to work with a professional wealth advisor, financial advisor, broker, et cetera. The DIYers, whether they were doing it themselves or delegating it, this is the first major decision in the road, then the next four steps that we’re going to discuss this evening would actually be incumbent upon the DIYer, the do-it-yourselfer, and/or a professional. So it’s really interesting after you make this first decision. So I think you have a great topic for tonight’s show because this is a very, very important fork in the road, and as you mentioned earlier, you know, you’ve got a great group of clients that we’ve cultivated over the years that you’ve introduced us to, professors, engineers, and I always say to them, you know, right off the bat, tongue in cheek, “Your IQ’s two or three times higher than mine is,” so, you know, it’s not on IQ test, but it’s amazing. I’ve had a belief in life that everybody’s an expert at something, and these are very bright individuals, engineers, chemists, physicists, et cetera, and physicians, whatever have you, but, you know, really, wealth planning, wealth management is really a completely unique topic, and a lot of people aren’t familiar with, regarding the do-it-yourselfer, a lot of the pitfalls or caveats or landmines that are out there in the marketplace. In making this decision, you need to be cognizant that there’s a lot of product selling that goes on, there’s a lot of conflict of interest from individuals. There’s always things that come along, years ago, whether it’s limited partnerships, and it gets into either front- or back-end-loaded mutual funds or non-traded REITs or high front-end load annuities of some type, huge pitfalls, not only could you potentially be paying a 5 to 7 percent or even a 10 percent or higher commission, but unfortunately, you may be restricted and be unable to get out of that investment for seven or eight or even 10 years or longer.

So that brings us to the first consideration an individual would want to think about: the fiduciary versus suitability standard. The fiduciary standard is what we’ve been under since 1989. As you said, we were one of the first few hundred fee-only firms in the country. The fiduciary standard, very simply, is that all of the advice we give is the same exact advice as what we would act on ourselves given the same situation, and I say even put more pressure on it. What I would do in my mother’s situation if it was the same, or one of my children’s or family members. Suitability is a lower standard, and individuals can read up on that, but again, if you were going to delegate some with a fiduciary standard, I think there’s been some great research by Vanguard and Morningstar, a lot of the listeners can recognize those names. They’re titans in the industry. Vanguard researched this topic of do-it-yourselfer versus delegator, and you’ve got to remember, Vanguard probably has more do-it-yourselfers than anybody in the country, and they’re the largest mutual-fund organization. They have literally tons of individuals who have their portfolio or portfolios at Vanguard and are managing the portfolios themselves. Vanguard completed some research a couple of years ago in which they refer to it as “advisor alpha,” and the advisor alpha that they identified were about 10 different areas that a good — and we want to emphasize “good” — fiduciary-based investment advisor, wealth advisor, can add value over the typical layperson investor, and it was surprising. When you take a look at it, some of the estimates between them and Morningstar, Morningstar refers to theirs as “gamma,” everybody’s got to call it something different, the trade market, so to speak, but they came up with 2½ percent, 3 percent, 3½ percent difference per year in the top 10 points of differentiation between the value that a good advisor can bring to the table versus an individual’s experience. It always reminds me of the old saying. If someone’s attempting to do something themselves, it reminds me of the old saying that you just don’t know what you don’t know.

3. Fiduciary Advisor Puts Client’s Needs First

Jim Lange: Well, interestingly enough, on this very radio show, when I was interviewing Jack Bogle at Vanguard, often at the end of the show, I say. “Is there anything that we didn’t cover?” And then, he kind of went into a two-minute talk saying that in today’s complex world, with the asset-allocation issues, estate planning being a whole other complexity, Roth IRA conversions, et cetera, that most of us need some help. So here’s the guy who is known as, let’s call it, the cheapest guy in America when it comes to fees, and even he is saying that people need some help. So, anyway, why don’t you go on? But I guess my point is that there are schools of people who are kind of known as low-fee investors who do recognize the value that an advisor can bring to the table, and, like you said, and this is very important and you just kind of went over it quickly, but I’m just going to stress it, is that the advisor that you want to be working with is a fiduciary advisor, meaning that they have not only the moral, because I believe we all have the moral, but the legal responsibility to do what is in your best interest, and if selling you a product that has a high commission where you can make more money is not in your best interest, and frankly, we don’t think it ever is, then they shouldn’t sell it to you.

So, for example, in our office, when we often recommend Roth IRA conversions and holding off on Social Security, we’re actually doing that against self-interest because we end up managing less money, and when I’m on the road giving talks to financial advisors, they say, “Well, Jim, how is your advice helping us? Because if we follow your advice, then we’re managing less money.” My point is, well, yeah, but you’re doing the right thing. But a lot of these guys are not fiduciary advisors. They’re selling products, and P.J., the way you and I work together where we’re splitting one relatively low fee, I actually worked out the math on it. To oversimplify, if somebody goes to an advisor and is sold one of these products that sometimes, like you said, have 5 percent, 7 percent, 8 percent, 10 percent, sometimes higher, commission, that you and I have to do 20 years of work.

P.J. DiNuzzo: Yeah.

Jim Lange: So you have to work for 20 years. I have to work for 20 years. Asset allocation, everything that you guys do, which is an awful lot, we do an awful lot, we have to do that for 20 years to make the same amount of money as if we sold somebody an annuity. And, in addition, we don’t get all the money up-front. We get a tiny bit Quarter 1, a tiny bit Quarter 2, a tiny bit Quarter 3, and if anybody’s unhappy, which we have very little of because we do have a 97 percent retainage rate, but if somebody dies, so it’s not a certainty. So, for the advisor, it’s great to sell these high-fee, high-commission products, but that’s not what a fiduciary advisor does.

P.J. DiNuzzo: Exactly. It’s quick money. As you said, we’ve got to work 10, 15, 20 years. It’s almost unbelievable when you run the numbers on that what our breakeven point is, but on the do-it-yourselfers versus the delegators, you know, the one point I would make is, the point anytime we discuss this on the show, because it’s a common topic, we’re never trying to talk a do-it-yourselfer into becoming a delegator. I think where the value is what we’ve seen, you know, you and I have been at this for over a quarter century, Jim, independently, and what we’ve seen is individuals who weren’t really maybe sure and had been doing it themselves, once they were further educated, I’ve seen individuals who start to work with an advisor who had been a do-it-yourselfer their entire life, just the weight of the world’s off their shoulders because they knew they weren’t really good at it, they hadn’t really found someone who was who they could entrust their life savings to. So, again, there is an awful lot of value to be added if you can find the right advisor. You know, the one thing about do-it-yourselfer versus delegator is that individuals would have a real hard time with what we technically call behavioral science. In layman’s terms, that would be the emotions of investing. We’ve even got a trademarked graphic that we refer to as the “investment roller coaster,” very, very challenging to get the quantitative side of wealth planning and retirement planning and retirement-income planning correct, even making it near impossible in my mind for the average house or the average individual to also incorporate the emotions of investing into their overall plan, again, just with a limited perspective.

And then, finally, I would say on the do-it-yourselfers, Jim, what we’ve seen over time is someone can be a very fierce and very independent do-it-yourselfer, and typically, what we see, and you’ve mentioned this a number of times on the show, is a typical family household comes in, spouses or same-sex partners, and one individual’s very strong on the investing, and the other, as we say, you know, doesn’t know a stock from a rock, basically. They defer to the more educated partner or spouse, who pays a lot of attention to this, and then sometimes it will dawn on the spouse who’s dominant on the investment side, heaven forbid, what happens if they were to predecease the other spouse?

Jim Lange: Or even just lose mental capacity.

4. Fiduciary Advisor Can Relieve You of Stress

P.J. DiNuzzo: Yeah, or something along those lines. So, we’ve been hired in numerous cases over the decades as … and the clients have even referred to it as an insurance policy to have an advisor in place that they do agree with that, heaven forbid, if something happens that they’re comfortable that their spouse or partner is being left in good hands.

Jim Lange: Before we go on to the next point, I also want to emphasize the emotional part that you brought up for two things: one, in today’s stress world, many people … I mean, I think that we provide enormous value, and if you compared where people are, let’s say, between using the combination of our strategies and Dimensional Fund Advisor funds and the strategies and asset allocation and the stack analysis and everything that you brought to it, even if it was a tie, which I don’t think it ever would be, the ability to not worry about money, and the ability to not worry that you’re doing the wrong thing, and knowing how much money you can safely spend, I think has really liberated a lot of people and has really changed people’s outlook and significantly reduced the stress in their lives, and particularly in today’s world, anything that we can do to avoid stress. Somebody was in today and the idea was, well, even if I’m not getting the top, top rate, which, frankly, I still think he is, and the top service, et cetera, the thing that’s good about for him was that he doesn’t have to worry about it.

P.J. DiNuzzo: Yeah. It’s a game changer.

Jim Lange: It’s taken care of.

P.J. DiNuzzo: Yeah. If you can find the right firm that’s aligned with your worldview, it’s a game changer.

Jim Lange: So, why don’t you talk a little bit about perhaps one of the most important things that I think that you guys do, and I think that you do a much more thorough job than any firm I know; can you talk a little bit about asset allocation and what kind of strategies you use when you meet somebody to develop an asset-allocation strategy?

5. Asset Allocation Is All About Balance, and It Changes Over Time

P.J. DiNuzzo: Yeah, Jim, and you hit the nail on the head. When we think of the phrase “asset allocation,” again, for the audience, that would be the percentage of stocks versus bonds in any individual portfolio, we refer to that synonymously in our mind as a strategy, and that strategy, at our practice, is developed based upon a purpose, and what our belief at our practice is that the strategy and asset allocation should be developed and should be a product of the entire retirement planning and retirement-income planning, what we refer to as our unique process. So most firms are looking just to manage money, and I still, to this day, don’t even know where some of these asset allocations come from that prospective clients come in with, but they establish 90 percent in stocks in a portfolio and 10 percent in fixed income or 75/25, 100/0, in a lot of cases, and I think that they’re working from that backwards. We would start off developing the plan, and as you had stated earlier, Jim, you know, I’ve always referred to it as the four corners in our personal financial house. You know, you’re an estate-planning attorney with a tremendous long track record with an estate-planning law firm, you’re a CPA with a tremendous long-term track record with a CPA firm. On our side of the room, you know, we’ve got a ton of CFPs, CHFCs, PFSs, specialists in planning for the retirement planning, retirement-income planning, and then that fourth corner, the investment management, and it’s really bringing that all together as we’ve referred to on the radio show a number of times, and what folks are getting offered, not only for a reasonable price, is basically almost a miniature family office offering. They’re getting all major four corners watched over and monitored and managed on an annual basis.

6. Investors Are Different and Require Individual Analysis

P.J. DiNuzzo: So on the development of the plan, really, that’s where the heavy lifting comes in, going through all the planning work that we do, which we’ve done other shows on that to get bogged down in that now, but getting to know each unique household. If we asked a hundred households “What does money mean to you?” we would get a hundred different answers. We never make any guesstimates. I refer very simply to putting a household’s retirement plan together that every household has a unique 10,000-piece jigsaw puzzle, and it’s a lot of work and it’s very unique and you can’t make any assumptions. You have to get to know each household personally. Then due to that unique household customization, what we typically produce, as you’ve seen, Jim, is usually two or three or sometimes even more asset allocations, and you referred to our bucket process, the DiNuzzo Money Bucket Stack Analysis. You know, first, we have a cash-reserve bucket, which is, of course, for your peace of mind. It’s kept in your local bank, FDIC insured. And then, the risk-capacity bucket for your needs, and there’s no way that you can assess any household’s needs other than doing the tedious work that we do to go down and get to know that household, going through line item by line item, and again, most folks have never done this when they come to us. We’ve done thousands of these.

Jim Lange: I mean, down to the cable bill!

P.J. DiNuzzo: Yeah, we often joke around with folks. We sort of get down to how much toothpaste you use on a monthly basis, so it’s pretty detailed. But the benefit of that is that when we’re making all of these professional estimates and we’re extrapolating data over the rest of your life for 25, 30, 35, 40 years through retirement, we have a tremendous amount of higher confidence, and Jim, if I haven’t heard that hundreds of times or thousands of times from individuals, you know, I’ve gone out and talked to other firms and they gave me an answer, and you folks gave me an answer, but I have tremendous faith in the answer that we’ve given them. Because of all the background and how we built that, they know that their numbers are in there, and they know that they got sort of a quick-and-dirty type analysis from somewhere else, and often these quick-and-dirty analyses are off by hundreds and hundreds of thousands of dollars from what our recommendation is.

Jim Lange: So, I think what you’re really saying, and I’ve heard you use this exact phrase many times, is that everybody is a snowflake. It’s not like, all right, we have three different models and we’re going to try to squish every single client into one of those three models. It takes more time. It takes more work on our part. But I think the client is much better served. So why don’t you continue with talking about the, let’s say, household customization and what you guys do.

P.J. DiNuzzo: Yeah, sure, Jim. The household customization would tie into, as we referred to the bucket analysis, a conservative to moderate allocation for the needs bucket, a balance to slash potential-growth portfolio for the wants bucket, for the wants expenses, those would be nonessential expenses, and then a growth portfolio or aggressive-growth portfolio for the dreams and wishes bucket. So, the dreams are assets that are available until the last spouse or partner passes away, and then the legacy portion would be, of course, the wishes would be for after the last spouse had passed away. So, typically, we will have two or three asset allocations, and again, this ties into not just the quantitative side, but the behavioral side that we talked about earlier.

The average individual in retirement just cannot handle a full range of volatility around their needs bucket, which we refer to as risk capacity, for the portfolio that’s paying for their electric bill, their gas bill, et cetera. I mean, Jack Bogle, as you said on your show, he’s famous for a quote that goes something along the lines of when everybody is telling you when the market’s going through a really bad period, to hurry up and do something, Jack’s famous quote is slow down and don’t do anything. So in order to keep individuals in their seat, it’s very important, because if we take a look at the data again from Dalbar that we talk about all the time, and individuals come to the party late, they leave the party early. If you’re following your emotions, you’re really going to be a very bad investor, is what you would typically see. So, with us, a reminder again on Step 2, this is a decision that if you’re a do-it-yourselfer or if you had delegated, either side of the coin, you have to perform. This is the single most important decision that you will make in the development and structure and building your portfolio, and again, which is going to be tied into your long-term success or lack thereof.

Jim Lange: And I will also just throw in that our offices work very well together in that we have different tax strategies for some of the different tax buckets. So, for example, the very long-term wishes bucket, or even the legacy bucket, that will typically be filled not only with, as you said, some of the greater growth, perhaps small companies, international, emerging markets, et cetera. But that will typically be where the Roth IRA conversion money is because that has the greatest long-term growth, which you would not invest like that for money that you need next week.

P.J. DiNuzzo: Yeah, exactly. That ties into the account type, and what your team has done, Jim, your team of CPAs in your office, when we run the numbers ourselves when we’re working together, I would say, on average, one of our nine wealth advisors is talking to one of your team of estate planning attorneys and/or CPAs on a daily basis working on our joint clients, and we identify, if the audience can imagine, once you’ve performed this analysis and you identify that you have enough money coming in from Social Security, maybe potentially a pension, maybe you have a gas lease or some royalties, whatever other income you may have, and once you calculate what your required minimum distribution’s going to be, you really, in a perfect world, would prefer not to have any additional forced income on top of that. You would not want to have an additional two or three thousand dollars of required minimum distributions that you have to withdraw from your IRA, that you have to pay taxes on to place you in a higher tax bracket, and that’s the money that, you know, you and your team, you know, we look at it as that top dreams and wishes bucket. We concur with your team of CPAs when you reach that calculation as well. Hey, let’s chop that down.

7. Seek Planning Advice at Least 5 Years Before Retirement

P.J. DiNuzzo: So the sooner we can get in front of someone, a prospective retiree, and we always like to remind the audience, you know, we like to get in front of individuals at least five years before retirement, ideally 10 years or sooner, but at least five years. It’s just amazing, brilliant individuals — I mean, it’s happened, Jim, just the last month or two, as you know — have contacted us saying that they’re getting ready for retirement, they’re thinking about retirement. I mean, in a couple cases, it’s been weeks. It’s literally been less than a month that they said, “I’m going to retire in two or three weeks.” Numerous cases, “I’m going to retire in two, three or four months.” “I’m going to retire by July 1st of this year.” We’ve got a lot of that already, you know, just working half the year, and a lot of other people are retiring by the end of the year. So the audience wants to remember, again, the more planning time that you have to correctly move your chess pieces on your chessboard, you’re going to reap phenomenal results often in the long term.

Jim Lange: Right, and you also have something that you call a soft landing, and you use an airplane analogy, which I think is helpful. Can you talk about that for our audience for a minute?

P.J. DiNuzzo: Yeah, for the audience, what we’ve done is, and actually, I mean, I would credit DFA, Dimensional, where I’d seen it before, the retirement-target date plans were developed in 401(k) plans, to come down on a declining asset allocation to have a safe landing at retirement. If the audience wants to think of it as if you could identify and look at it as a challenge, what would my ideal portfolio look like? Let’s just take one of these buckets, let’s say the wants bucket, for example. For our non-discretionary spending, what would my ideal asset allocation/strategy be for that bucket? And let’s just say that it’s 50 percent in stocks and 50 percent in bonds. It could be 60/40; we’ll use 50/50. If you did know that, then you would want to be on a glide path, as we refer to it, so that you would have a soft landing, as Jim stated, at the point of inflection when you retire. We often see individuals that need to be … again, we use the same example, at 50 percent in stocks at retirement, and they are coming to us. We just had a case last week that the household retirement plan was 90 percent in stocks, and that just doesn’t make sense from a multitude of perspectives, and really, the household, for them, the soft landing would have been around 60 percent in stocks. So, the audience needs to consider, how do you get from 90 percent to 60 percent? It’s not a soft landing, and the risk that you run is if you’ve overexposed equities and you’re on that final approach to your retirement, which you want to be a soft landing, and the market were to go down, a correction of more than 10 percent or a bear market of more than 20 percent, that can throw a monkey wrench into the gear of your retirement plan and, for the title of the show that you had, Jim, expose you to unnecessary risks that could have been easily avoided.

Jim Lange: OK, so you’ve given us a little bit of an idea of asset allocation. Well, what about diversification? What’s the difference between diversification and asset allocation?

8. Diversification of Investments Protects Against Overexposure

P.J. DiNuzzo: Asset allocation would be the big picture, the strategy, the percentage of stocks versus bonds. We want to remind ourselves that risk and reward are equally related. A 60-percent-in-stock portfolio will grow more than a 50 percent stock portfolio over time, but again, it will bounce up and down more. We’re not so much concerned about the upward bounce as it would make more but when we’re in a down market.

The next step, which would be Step 3, as you mentioned, Jim, would be the portfolio diversification. So if you decide on an asset allocation, for one of your portfolios, for one of your buckets, it should be, for example, 60 percent in stocks and 40 percent in bonds. To oversimplify, the first observation will be, “Well, should I just place one stock mutual fund for my 60 percent in stocks in my portfolio and one bond mutual fund for the 40 percent in bonds in my portfolio?” As listeners can imagine, that would not be meeting the definition of diversification. You would want to take a deeper dive than that. And it’s not so much the thought of just one mutual fund because the audience of listeners could say, “Oh yeah, I would never do that,” but the individuals that we see coming to us with maybe even sometimes they own individual stocks, and of the individual stocks they own, they’re all in the technology sector of the S&P 500, so they’ve got concentration in their portfolio, or they own certain types of mutual funds with three or four different mutual-fund families, but they all have the same objectives.

So, again, it’s very easy to be distinctly under-diversified. So, again, the equity diversification on the stock side, we want to be exposed to multiple areas. The way that we refer to it is, we talk about the stock market roller coaster, there’s about a dozen roller coasters, let’s say, across the globe that are moving and are located at different points in different places in time. For example, you have U.S. large stocks, U.S. large value, small, small value, real estate, you have the same asset classes internationally, large, large value, small, small value, emerging markets as well. So, you want to be diversified, not having all of your eggs in one basket, and the benefit here is that with the indexes, with the Fama/French indexes that Dimensional follows, right now, we have an 89-year track record for the U.S. indexes, and over a 50-year track record for the international. You’re just not going to find anywhere near that type of track record with an active manager. So there’s a lot more comfort in building these portfolios, they’re more statistically significant, et cetera, to get down into the sausage factory. But equity diversification, and then the fixed-income diversification on the bond side, what our recommendation would be for the bond diversification would be to have short intermediate-term high-credit quality. When we look at a portfolio, and we need to be careful for compliance, talking about specific percentages, but let’s just say a portfolio such as DFA or Vanguard, if you’re accessing large, large value, small, small value, real estate, international, we’re about two thirds U.S., one third international, a 60/40 portfolio, 60 percent stocks and 40 percent bonds, was down in the low 20 percent range in 2008. Just talking about a broad index portfolio tilted towards those factors, down maybe in the 23 percent range, the average 60/40 portfolio in the United States, and with professional managers, I might add, was down 30 percent or more. So, that’s really where the diversification showed up, that individuals, although they were at 60 percent in stocks and 40 percent in bonds, had concentrations. There were numerous 60/40 portfolios that I saw after 2008 that were down 30 percent, 33 percent, 35 percent or more when the benchmark indexes … again, and I’ll include Vanguard in there, if it was built properly, would have been down only in the low 20s. So you were down $100,000 to maybe $150,000 more of a loss in ’08 on a million dollars, to use that as a benchmark. So, again, it was the topic of the show of what pitfalls are avoidable, et cetera.

What we were talking about value, small, et cetera, we would recommend tilting your portfolio, as we refer to it, to the known premiums in the market. Everyone who’s invested in stocks is invested for some reason, most of them aren’t invested for, what we would call, the reason, for the equity-risk premium. There’s a very high probability that if you have a reasonable holding period, a long enough holding period, that stocks are going to do materially better than bonds. That’s why we own them at our practice because of that probability for that equity-stock premium. The other rigorous premiums are value, value’s done better than growth, predominantly for, again, reasonable holding periods over an 89-year period of time. Small’s done better than large, and then the newer premium identified by DFA and Professor Marks from the University of Rochester in New York is the direct-profitability premium. So those four, the key in the stock side, on the bond side, the premiums are term. As the audience can imagine, the longer term 10-year bonds pay a higher rate of interest than five-year bonds, 15-year bonds on average pay higher than 10, and then the credit quality, the lower the credit, the higher the yield. So you need to be careful.

You know, Jim, you and I are seeing tons of portfolios with individuals that are coming in now, because interest rates have been so low for so long, and individuals are really pushing that envelope very far, and I would argue off the table in a lot of cases, going with very low-credit bonds, going with very longer-term bonds trying to chase yield, and if or when, more like when, not an if, we get into a rising interest-rate environment, a lot of these individuals are going to be very surprised when they see how far their bond prices and the value in their bond portfolio’s going to decrease when that occurs.

Jim Lange: I want to just mention one thing that you said, but I want to emphasize, because part of our process is people start with coming to our firm first, and if we are a good fit, and it takes a while to figure that out, but after a meeting with me, if I like the client or the potential client and they like me, we have a process where we take all their statements, we put them into Morningstar, which is an objective reporting service, and that shows us what their asset allocation is, and then we give them an idea of where we think they should be. Interestingly, I just did one today, and believe it or not, it’s a very well-known firm, and I don’t want to say their name because it will not make them look good at all, but the client in that firm had a zero percent asset allocation with small companies. And I don’t mean mom-and-pop grocery stores, but let’s say billion dollar instead of a hundred billion dollars. Now, the small company, since 1928, has performed roughly, maybe, 3 percent or 4 percent better than the large companies, depending on which sector of the small companies, and that’s something that would be, let’s call it, in your long-term wishes bucket. This individual didn’t have any of that, and I would say, “Boy, what a terrible mistake, because he’s missing that 3 percent or 4 percent premium, and, in addition, he has all his eggs in one basket, so if large U.S. companies don’t do well, he really has a problem,” as you pointed out when people lost a lot more money than they should have.

So, P.J., one of the questions that investors have to face is, should they try to beat the market, or should they try to be the market? So beating the market would be active money management, being the market is passive money management. Can you tell us the difference between the two, and, let’s say, historically, who has done better? The active money managers or the passive, or index, money managers?

9. The Market Is Efficient, Which Makes It Hard to Beat

P.J. DiNuzzo: Yeah, sure, Jim, and this, again, for the listeners if you just tuned in, is under the title of how to be a successful investor. Step 1 was do-it-yourselfer versus delegating, delegating to a wealth advisor, financial advisor, et cetera. The second step was choosing your asset allocation, your strategy for multiple portfolios, not just everything in one basket. Step number three was full and proper diversification. We went through that in detail, and after Step 3, Step 4 would be, as you identified, Jim, now that you’ve diversified, and say, for example, for the audience, we’ve determined that we want to have 14 percent in U.S. large stocks and 14 percent in large value, 7 percent in small, 7 percent in small value, 7 percent in real estate, et cetera, our next question is, are you going to attempt to go into each of those, if you want to think of them as pie wedges, the tradition which you’ve all seen, the pie chart, and do you want to go into that specific pie wedge, for example, U.S. large value, and do you want to try to outsmart the market to pick an active U.S. large-value stock manager, or do you want to invest in the index that’s in that market space? So the national benchmark would be the Russell 1000 Value Index. We’ve been under the philosophy since 1989 that the market is efficient. We were using Vanguard funds decades ago before DFA was available, and then whenever DFA became available, we knew, in our professional opinion, that they were the best, but they were not available to us until around 1994, and I think Dan had said earlier that we applied and were accepted as one of the first 100 firms in the country. So, to us, the research has always been clear to me that the passive route, aka indexing, and the passive route and indexing is really all about efficient-market theory, and it could sort of turn into a pretzel if you can’t keep your bearings on this. But if you think about it, it’s really because all of these brilliant, and there are seriously some individuals who are managing money at some of the active mutual-fund companies who are … you know, you could maybe call them investment geniuses, and they’re very bright people, very bright teams, et cetera. But it’s because of all of these very bright individuals who are pricing out Google and Facebook and Microsoft and Johnson & Johnson and Proctor & Gamble on a second-by-second basis that makes these stock prices so efficient, so fiercely competitive, millions of very intelligent individuals pricing out stocks on a second-by-second basis, that it becomes, in our professional opinion, next to impossible to be able to outsmart the market consistently, especially over long periods of time. And we would refer to, at our firm, that anything even under five years is just noise in the markets, so you can take a look and say, “Oh, I’ve seen some guy or gal outperform the market for six months, or a year, or two or three years,” usually, what you’ll see after the dust settles that they were just in the right sector at the right time. They were a U.S. small-cap manager and small cap outperformed for three or four or five years and they can tout that they beat the S&P, which is an incorrect comparison. So in our belief, the stock market is very efficient. It’s the topic, arguably, that Professor Fama from the University of Chicago Graduate Business School was touting when they awarded him the Nobel Prize a couple of years ago, efficient-market theory; again, this concept that buying and holding specific areas of the market, be they U.S. large stocks, U.S. small stocks, et cetera. And one misnomer that a lot of individuals have about indexing, for some reason, they think that they’re a very monolithic or static or stagnant investment process, but, in my mind, it’s nothing further from the truth. Indexing, if you think about it, is truly survival of the fittest. I tell folks, when I was in high school, General Motors and Bethlehem Steel were two of the 10 largest companies in the stock market. They’ve long ago gone bankrupt. Their stock, if you owned it, went to zero. Now, when I was in high school, Microsoft wasn’t a twinkle in Bill Gates’ eye yet, and now Microsoft is one of the 10 largest stocks in the stock market. So, it’s survival of the fittest. You need to continue to grow, to continue to be profitable. So, we let the market take care of that, and no individual’s going to be able to have tomorrow’s newspaper or a crystal ball to stay ahead of that. So, yeah, when you start taking a look at over 10-year periods of time, you’ll see that indexing is outperforming active managers, on average, about three out of four times. So what our story is, and what Jim led off with at the beginning of the show, to be a successful individual investor, let’s control what we can control and avoid common pitfalls and mistakes that are made by the typical average individual investor. There’s a lot of elements that combine to allow indexing also to be more successful. With active mutual funds, historically and currently, you have things such as front-end or back-end loads, as far as percentages to buy or sell a mutual fund. Built-in 12b-1 fees, rebates, and again, you see these rebates show up in lawsuits, but it’s a very competitive environment. You see active mutual fund families paying for access into certain portfolios, et cetera. Surrender charges, there are redemption fees for a lot of investments, as Jim had mentioned earlier, may cost you 3 percent, 5 percent, 7 percent, 10 percent or more to sell out of the investment that you had purchased, and those are huge drags on performance, I mean, I would argue, drags on performance that you will never recover from, how large some of these fees and charges are. Then you’ve got the ubiquitous, always-there operating/expense ratio, and again, we never sell anything. You know, Jim, you do a great job because you provide a ton of value, and we feel very confident in our value proposition as well, but the facts are that what we do, the investments that we’re in are typically lower than 99 percent of the clients that come to us, very intelligent individuals, but our typical DFA portfolio — 50/50, 60/40, 70/30 — the average of the expense ratio in that portfolio is around 30 basis points, 3/10ths of one percent. We have individuals, I would say the last five cases that came onboard on average were 70, 80, 90 basis points. So, again, in plain English, about one-half percent or higher, just on the investments alone, so an individual can be, to the point you had earlier, Jim, a do-it-yourselfer, thinking that they aren’t going to pay anybody for anything, when we have case after case that comes to us that we actually literally pay for our entire fee or more just on the cost savings and the expense savings we’re able to pass along to our new clients who come onboard with us. So, again, we’re not leading with that, but it’s just an inherent benefit of doing things the right way, following efficient market theory, of investing with the best companies, and again, Dimensional Fund Advisors we feel is the best at what they do, so we believe in efficient market theory, we believe that in order to access that and for you to benefit from it, you want to do that through indexing, and we feel very confident, again, that Dimensional Fund Advisors, we would stand by their four decade track record versus the rest of the market. On the active versus passive concept and conversation again, some of these are very often overlooked, but just provide huge decision points, points of inflection, that that proverbial fork in the road, just the consistency of passive managers rather over active, with passive managers doing better over time, the consistency, even whenever the index versus the active managers doesn’t do that well, it’s still, over a period of time, doing better than 35, 40, 45, 48, 49 percent of active managers. So the bottom has never fallen out of any index that we follow at DFA where you’ve got, on average, hundreds and hundreds, and sometimes there’s been a thousand or more, but hundreds of active mutual funds that are closing on an annual basis because they’ve underperformed the index. There’s no index mutual fund that we deal with that’s ever closed in our entire career. It just wouldn’t make any sense. Large, large value, small, small value.

The next one is turnover in a portfolio. The indexing turnover, our entire goal is, across the board, you know, Jim, your firm and ours together, we’re drinking from the same water, so to speak, buy and hold, we want as little turnover in clients’ portfolios as possible. I mean, the old saying, you know, your portfolio’s like a bar of soap. The more you fiddle with it, the smaller it’s going to get. You know, you want to buy and hold. You want to have strong convictions in the positions that you’ve taken, and you want to maintain that turnover as low as possible, because where the turnover comes in and where it really rears its ugly head, and I still, to this day, I’ve been doing this for 28 years, and I see cases almost on a monthly basis that it’s an active strategy, and you could argue it’s even an above-average active strategy, and it’s in a taxable account for an individual, it’s in a joint account or individual account, but due to the high turnover, the amount of gains that the individuals recognize on an annual basis are outstanding. We had a case recently that an individual was recognizing on average, I think it was even the last 10 years, between $40,000 to $50,000 in realized gains from the investment strategy that they had delegated to, when in an all-index portfolio at the same asset allocation, the capital gain distributions would have been about one-third of one quarter of that. So, if the audience can imagine, it’s the age-old saying it’s not what you make, it’s what you keep, and if you are paying tax on $50,000 of income per year, because remember, again, if you’ve got an after-tax portfolio, individual or joint, yes, you want that to grow. We all want that to grow, and you want to have as little trading in there as possible. You want that to grow net as well as possible over time. So, the tax inefficiency, even upon first glance, if some active strategies would look to be a good strategy, very tax inefficient. The next thing we see that’s often forgotten is the cash-performance drag on holding cash in a portfolio. Our typical portfolio, our goal going in, if there’s no withdrawals, is 1 percent cash in the portfolio. Our goal is to be 99 percent invested. We’re often 99.2, 99.4 percent invested, and if you juxtapose that against other managers who have 5, 10, sometimes even 15 percent in cash, that’s a huge drag, and also one that disturbs people because they’re paying a full management fee on 5 or 10 or 15 percent in cash. The bottom line, I would say, Jim, again, on active versus passive, is that total costs matter and that the individual needs to keep that at the very top of their mind.

Jim Lange: Well, P.J., you’re not alone, so on this program alone, we have had what I would consider the champions for consumers, people like Jane Bryant Quinn, who has been sticking up for consumers for 30 years; Jonathan Clements, who wrote for TheWall Street Journal for 18 years, he was their chief personal writer; Charles Ellis, who wrote a book called The Loser’s Game, which is chasing the best active manager, of course; Jack Bogle, the founder of Vanguard; Burton Malkiel, author of A Random Walk Down Wall Street; Roger Ibbotson. So I guess what I’m saying is, all the champions for the consumer are also saying the same thing that you are, that passive makes a lot more sense than active, passive being index compared to trying to pick which stock or which sector is going to do better in the short term.

Dan Weinberg: All right, thank you so much, Jim, and thanks again to our guest P.J. DiNuzzo. And listeners, if you’d like to meet with Jim Lange in person, give the Lange Financial Group a call at (412) 521-2732 to see if you qualify for a free initial consultation. You can also connect with Jim’s office through his website at www.paytaxeslater.com. And while you’re there, check out some of our previous shows. You can hear more than 150 hours of shows featuring some of the top names in investing and retirement planning, many of which Jim just mentioned there, and the best part is, it is all free. Special thanks to the Lange Financial Group’s marketing director, Amanda Cassady-Schweinsberg, and to our producer, Amy Vallella. I’m Dan Weinberg. For Jim Lange and P.J. DiNuzzo, thanks so much for listening and we will see you next time for another edition of The Lange Money Hour, Where Smart Money Talks.